E375: Why Tax Alpha Could Matter More Than Investment Returns

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24:33Get started today. Support for today's episode comes from Square, the all-in-one way for business owners to take payments, book appointments, manage staff, and keep everything running in one place. Whether you're selling lattes, cutting hair, running a boutique, or managing a service business, Square helps you run your business without running yourself into the ground. I was actually thinking about this the other day when I stopped by a local cafe here. They use Square and everything just works. Checkout is fast, receipts are instant, and sometimes I even get loyalty rewards automatically. There's something about businesses that use Square.

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25:36And right now, you can get up to$200 off Square hardware when you sign up at square.com slash go slash how I invest. At Square, you get all the tools to run your business with none of the contracts nor complexity. Run your business smarter with Square. Get started today. Support for today's episode comes from Square, the all-in-one way for business owners to take payments, book appointments, manage staff, and keep everything running in one place. Whether you're selling lattes, cutting hair, running a boutique, or managing a service business, Square helps you run your business without running yourself into the ground.

26:07I was actually thinking about this the other day when I stopped by a local cafe here. They use Square and everything just works. Checkout is fast, receipts are instant, and sometimes I even get loyalty rewards automatically. There's something about businesses that use Square. They just feel more put together. The experience is smoother for them and it's smoother for me as a customer. Square makes it easy to sell wherever your customers are, in-store, online, on your phone, or even at pop-ups, and everything stays synced in real time. You can track sales, manage inventory, book appointments, and see reports instantly whether you're in your shop or on the go.

26:42And when you make a sale, you don't have to wait days to get paid. Square gives you fast access to your earnings through Square checking. They also have built-in tools like loyalty and marketing, so your best customers keep coming back. And right now, you can get up to$200 off Square hardware when you sign up at square.com slash go slash how I invest. At Square, you get all the tools to run your business with none of the contracts nor complexity. Run your business smarter with Square. Get started today. It means that it could offset things like wages or other business income. This surprises people because this is unfamiliar in most areas of income tax planning.

27:19This is just a fascinating product suite that has come out of, let's say, financial innovation. And again, I would say there's a couple different things to keep in mind here. One, these strategies are meant to produce alpha. And they come in two different flavors. One is market neutral. And another one is beta or index-ish. They're not index. They're incredibly high tracking here. But they are beta versus market neutral. And I think, again, there are two different layers to this. One is that they are made to generate alpha. They're made to take risk. And second, they're made to provide certain planning opportunities for investors.

27:52These things go hand in hand. You do not get the planning opportunities without taking risk. And so those two things, I think, pair really nicely. One more thing. Everybody always forgets this is not a complete bonanza. What needs to happen is that when you have a hedge fund structure, the hedge fund can pass through losses, again, subject to certain constraints. They are ordinary. That's really interesting. But they are limited. And they are limited in three important ways. First is cost basis. You contribute a dollar. You can lever up a portfolio. It increases bases. You can pass through those losses.

28:19That's the first gate. The second one is what's called at risk. So I said limited before. Limited is the key word. If you have a limited partner, the limited partner has limited risk. What does that mean? It means that they have a limited amount of tax loss that can flow through before they are no longer liable. This is interesting for you, David, and your audience, but you know the difference between a limited partner and a general partner. General partner personally liable for certain line items attached to the structure. well, they can realize more losses that flow through to them as partners.

28:46So again, limited versus unlimited loss. And then the final one here that's material, there's actually two more. One of them is passive, but these are active vehicles now. So that's not an issue in this case. This is not a real estate fund where you're worried about passive losses. So that's not relevant in trader funds. But the fourth thing that investors need to know about limitations on losses passing through is what's called EBL, and that's excess business loss limitation. It's written into the code. It's section 461 or something like that. But you can look up the form and it will tell you what the dollar amounts are that cannot be exceeded in a given year.

29:20And then those losses carry forward to future years as net operating losses. But the important thing that I hear is that basis, at risk, and EVL are the limiting factors on what can flow through to an investor from a trader fund. And those just limitations are worth keeping in mind when you're thinking about an allocation of some of these products. I know there's different companies, different products, but give me a sense of scope. Oh, like in terms of size, you know, we're talking about billions and billions certainly invested in these strategies. I can only think of three, maybe four that are actually doing this in the marketplace right now.

29:54There might be more I don't know about. I'm curious, you're talking about passive versus active. Many of our listeners are investing in the GP stakes part of the business as well. Is there a way for family offices to invest in the actual GP and get even more tax alpha? Have you seen that?

30:12Usually not. You would have to not not as an investor, you'd have to come in as a partner. And you'd have to probably work with the fund managers to figure out the specifics around that. But there are there are structuring opportunities for GP like exposure. And I think the point that you're I think the point that you're getting at is that if you're a limited partner, you kind of had limited pass through of tax benefits. And but But if you were a general partner, you could overcome that. I've seen one instance of that in the brokerage land, which would be what's called a guarantee letter. And essentially, if there was any limitation on losses, then the guarantee letter would say, oh, no, we are personally liable, and the tax losses would flow through.

30:48It essentially unbreaks the dam that was blocking the tax losses. But in hedge fund land, that would be a little bit different. You'd have to talk with the fund company who's got their own GPs on it, and they're doing their own planning. let's talk about failure modes whether tax loss harvesting or trade or funds obviously they feel kind of too good to be true how do these strategies fail one of the things that's coming up a lot now in the brokerage side so set aside hedge funds for a minute but in the brokerage side there are a lot of limitations by the custodial brokers that are out there and so we're talking about generally like fidelity and schwab fidelity and schwab have in their own ways introduce limitations on the growth of the strategy, whether it's opening new accounts in the case of Fidelity or the financing cost applied to certain clients on those platforms.

31:37And then at Schwab, a limitation on the overall book of business that an advisor can bring, it's something like 30%, can only be, is the limitation on the book that can be applied to long short. This sounds mechanical and really boring, but actually, this is where the rubber meets the road. And what do I mean by that? So if your advisor, and these are advisor access solutions, if your advisor cannot access the strategy, because the custodial layer is limiting that in some way, that's actually the most concrete barrier to using the strategy. I mean, it's very practical. They just shut the door.

32:08You can't do it. All right. So that would be one risk is that you are attempting to allocate to the strategy. You simply can't access it. I mean, that's a very practical barrier. But what could go wrong? The top line item here, and this is worth diligencing thoroughly, is just, is the manager going to outperform? And if they don't, then is the strategy worthwhile from a risk and cost standpoint? These strategies are very costly. And so just a really quick rundown, we've got management fees, which tend to be elevated depending on the leverage. We have financing costs, you have margin, and the margin is mitigated by interest paid on short proceeds.

32:42But that's still a number that you need to reckon with. And then also the short positions have what's called borrow fee. And borrow fee is just what it costs to hold a short position open. And so all of these different fees, and also the turnover on these portfolios is high. It's hundreds and hundreds of percent. And so what does that mean? Transaction costs. Like I know everybody thinks, oh, it's, you know, it's the Robin Hood era, you know, everything trading is free. It's just not. And so all of these costs really add up over time. And so the manager needs to generate alpha to really make these strategies economical.

33:11Yes, you'll get all the tax benefits, but the alpha needs to be there. And so if they underperform, extremely long-winded answer to what could go wrong, if they underperform, then these strategies start to look really weird from a risk reward, you know, after all costs are concerned. And in terms of management fees, we're talking about 100 to 200 basis points. First of all, the management fee tends to scale up and down depending on the amount of leverage applied to the portfolio. But, you know, we could, I've seen, you know, portfolio management fees which are in the 20 basis points with really, really minimal leverage.

33:39And then, you know, 200 basis points plus when that leverage starts. And then how do you quantify borrowing costs and interest rates and put a number on that? It varies over time, but typical margin, I think right now we're looking at 6%, 7%, something like that. And these things are all roughly benchmarked to the treasury curve. But the important thing is the difference between margin and short rebate. And that margin gap tends to be ballparked very loosely, about 100 basis points. At times, it's been much tighter. 60 basis points was the standard at Fidelity for quite a while. They increased that for certain clients up to ballpark 150 basis points.

34:17Schwab, Pershing, Goldman. They're all running their own programs. They're all charging different rates. But if we're talking about through the middle, again, that's margin minus short rebate. 100 basis points is really the number to keep in mind, subject to the amount of leverage that's applied. Borrow fees are a little bit different. If we're talking about large cap names, 25 basis points of borrow fee. Again, that is scaled by the position and the leverage that's applied to the portfolio. But it's not unrealistic for a 200-100 to have 20 basis points of borrow fee attached to it, 20 basis points.

34:47So for folks who are used to index investing, you know, three to five basis points for the entire structure. Now I'm saying, oh, it's 25 basis points or 20 basis points, whatever, just to hold a short book. And so like these costs add up substantially. So maybe we can add that up for the audience. All in management fees, borrowing costs, interest rates. What's the all in fee or all in range that you would put on that? 150 basis points to 300 basis points. Got it. So 1.5 % to 3 % per year for these strategies, certainly 6 % to 20 % times larger than typical long-only. But here's why I would disagree.

35:19If you're paying 150 % to 300 basis points, certainly not cheap, but the tax alpha, I went back, I referenced a simulation. Obviously, simulations are prognosticating, right? You shouldn't rely on it for tax planning. That being said, many of these simulations at the higher leverage size predict about a 7x over 10 years or 70 % tax alpha on cap gains per year. What does that mean? Dollars and cents? You put in a million dollars, you get back a$700 ,000 loss on a yearly basis. You multiply that by some jurisdiction like New York or California. Let's just make them that simple. 35%. That's 23 % or 2300 basis of alpha in that year netted versus this 1500 to 300 costs.

36:11Now we're not, we're, we're assuming that the manager does not have any positive or negative alpha. And in other words, they basically just track the index, but we're talking about orders of magnitude of difference in terms of the tax savings versus the cost. Where am I wrong? I don't think that's wrong. In fact, I've got a buddy who runs some of these strategies, and he says the cost, you know, tens of basis points on management fees, and then you've got hundreds of basis points of tracking error. So the deviation of the strategies from the benchmark, and then you have thousands of basis points of accumulated capital losses.

36:48And so what is the planning opportunity between these things? So really, the question that you're asking is, like, from a net present value, We can do net present value on tax assets and liabilities. In fact, we should. A lot of people don't do it this way because it's tricky. In general, are we coming out with a net positive or an MPV that's positive from this allocation? Like is the planning, is the cost of achieving this planning flexibility net positive on an after-tax basis? Generally, yes, but subject to a thousand different constraints. It's really, it's worth just understanding how much risk is getting embedded in the portfolios and that really the portfolios need to be profit-seeking from an economic substance type standpoint.

37:23And so that is the gating concern. Is the manager going to outperform, underperform? Great. We're taking a lot of risk here. And the tax benefits sort of emerge as a secondary consideration. The planning opportunities are substantial, don't get me wrong, but these are profit-seeking strategies and they need to be evaluated as such first. I'm glad you brought up tracking error. I've had this argument dozens of times with wealth managers trying to get a wealth manager that will disagree with me and prove me wrong because I'm looking for the null hypothesis. To me, tracking error just says that you are betting on the jockey to make a distinction between different assets.

38:01I mentioned Ford and GM. They're going to choose between those two, which one to go long, which one to go short. And of course, if you make that directional bet, you're going to track against the index in one direction or the other. To me, tracking error is just another way to say the manager is trying to generate alpha. And I believe, worst case, if you pick a good manager, they're going to be either flat to the index or maybe slightly above. Because, again, they have some of the smartest people in the world. Going back to the second gen, the Nepo baby. They're betting against the Nepo baby. At this point, everybody is so passive that there's only Nepo babies around going active.

38:40And they're betting against him or her. And at the very worst, I think they're going to bet 50-50. I actually think, you know, very likely they'll get some alpha, maybe 100 to 200 basis. Maybe it completely wipes away that management fees and all those carrying costs that we talked about. But why is tracking error always looked at as a negative thing? This is such a crucial point. And so, yeah, tracking error comes in like two different flavors. The first one, if you have a low tracking error manager, somebody who's doing direct indexing long only, Their whole incentive structure is to keep their portfolio as close to the benchmark as possible.

39:17So tracking error to them is incidental. It is a cost of doing business to get into this tradeoff in risk and tax. And with an active manager, it's totally different. They want the tracking error. They see that as their kind of IP manifest in the portfolios. And so think about it this way. Like if a naively constructed market cap weighted benchmark, right? S &P 500, something like that. I'm not saying it's totally naive, but I'm saying market cap weighted. They're just like managers who are really leaning into tracking error as a differentiator are just like, we reject that as a means of wealth management.

39:46In fact, we reject it so hard that we're going to actively construct risk and we're going to manage it as such completely decoupled from the benchmark. We see the benchmark as in some ways arbitrary. We will measure risk relative to the benchmark because that gives everybody a toehold that they can understand the total risk in their portfolio. But in general, we reject that benchmark as a prudent risk management and alpha generation strategy. So we're going to do things totally different. So again, two different perspectives on tracking error. One, incidental. It happens. It's a cost. Goes up and down a little bit.

40:19And then the other one is really deliberate, calibrated. We like tracking error. The reason we like it is because it lets us manifest our perspective in the portfolio.

40:30so because some firms aren't even trying to play active manager to them the tracking error is just a tracking error it's just how closely they could get to the index and then others are saying well this is our source of alpha what you call tracking or we call alpha so we're gonna we're gonna really go for that yeah we like it that's that's part of how we manage money is we we don't care about all this market cap business like that's silly to us like we take active risk and And the reason we do is because that is what portfolio construction means to us. I hear that all the time. You get folks who are very passionate about this.

41:01They see this as the fruit of their work. Tracking error is not a bad thing to them. Tracking error as a mathematical idea is pretty simple. A difference. It's the standard deviation of the difference between the benchmark and the actively managed portfolio. And so this is not necessarily a bad thing. It could wildly outperform. It could underperform, of course. But they see that outperformance as a manifestation of their risk management. and stock picking ability. Many of these sophisticated strategies, whether the trader funds, typically 500K minimum, the tax loss harvested, oftentimes a million plus.

41:34There's now this new generation of tax loss harvesting for the masses, which is a bit of a funny, funny idea. But that aside, there's startups like Freck and others are going after the space. Are there any startups and or solutions that you like that are for the masses? Transparently. I think long short is a really is very strange for the masses, not in a condescending elitist kind of way, but just because it's so gnarly, and it just is a planning product. And so what does that mean? It means that you're accelerating losses. And those losses like require diligence, and you know, studiousness and planning and utilization.

42:11And do people really understand the costs that they're paying again, portfolio implementation, management fees, etc? Like, do they really understand that cost as a means to accelerating losses that maybe don't need? Okay, like, it's just, it's tricky to me to sort of balance those two. That's at the planning layer. At the implementation layer, my, just the work that I've done in risk management just suggests that you really want seasoned professionals working in the gnarliest chunk of the portfolio, which is really around margin and short management. And I really don't want to be surprised by inexperience in those two sleeves of the portfolio with so much risk taken on just really boring routine things what happens with a stock split when you have a short position what happens like what happens if you get one name that's liquid or you know different kind of corporate action what happens if you get a liquid name and you have an illiquid sort of other name and like does a startup know what to do with these things unless they unless they have insourced that talent like i really want i want folks who've dealt with like once in a decade scenarios behind the scenes at the manager layer.

43:16And to kind of start up, bring that to bear, possibly. I'm not saying full stop. I would just need extra convincing. So yeah, those are some of the things. I've got one more layer of concern, which is just like the institutional pricing just will tend to be much better from a custodial relationship perspective. In other words, AQR is going to get way better pricing than a startup would. And so when folks are just like, I don't want to have an advisor, you know, whatever, I'm going to pay all these fees. It's like, you'll pay them at some point. It's just a matter of like to whom you will pay them and what you're getting for that payment.

43:45And so those are the things that are going through my mind. You're making an important distinction, which is we talked about before, does active management return? Is it inherently a negative thing when you take away fees or can it be a positive thing? So, you know, my thesis, just for the record, is I think a good active manager can deliver 100, 200 basis points per year, even on a long only portfolio. What you're getting at is something, a different layer, operational efficiency, operational implementation, where there I would argue, there's economies of scale. The bigger you are, the longer you've been doing for, you don't get some extra alpha for being a small manager or putting in operations.

44:22There's only downside there. So you're bringing up an important and underappreciated thing that doesn't show up in the numbers. You could be a startup and you could put up a website that says, well, 0.25 % fees versus 0.5 % against the competition where you're not really showing what you're hiding is the operational risk. 100%. That's the kind of stuff that makes me really nervous. And just again, back to like my sort of like interest to the mechanics of tax management. A lot of this operational stuff is also pretty mechanical. There's no thesis behind it. It's all just risk management. And risk comes in a thousand different shapes and sizes.

44:53And I want really, really, really experienced risk managers behind the scenes of market risk. Yes. But all of the operational boring stuff, it would just be such a shame to have this like this really rich, you know, alpha strategy just be completely derailed by something operational like a stock split. I'm not saying those things are equivalent. I'm just saying like in aggregate, if you have all these operational concerns and they're just sort of bumbled, like why would you even bother with that? And what you're trying to do is eliminate the advisor like as an access point. By the way, just advisors come in all different shapes and sizes.

45:27If you just want access to the strategy, there are advisors who will work with you on a very minimal engagement. And so what are we doing here? Are we talking about like a UI on an app? Like, come on, you know, that's not something I care about in wealth management, right? I mean, I want all the risk and alpha stuff dialed in. And by the way, one more thing, all the way at the top is the primary gating concern for long, short alpha. These things must make sense on a pre-tax basis, and they can. But if you have, I don't know, a startup that's kind of just doing this over the last year or so, what do they know about generating alpha?

45:58Are they using some off-the-shelf model or whatever? Why would that be equivalent to what's been happening for decades at some of these managers? How would these things be equivalent? And so these are just the things that are going through my mind. Again, I don't mean to be down on the startup community or anything like that. I'm just like, I'm thinking about it from a risk standpoint. And I'm just like, why is that like, how is that well compensated risk? I also don't like to go short any startup or any solutions, but you have to, we're truth seeking here, want to deliver for the audience. If you could go back to younger Brent, when he was just graduated college, and you could give yourself one piece of timeless advice that would have either accelerated your career or helped you avoid constant mistakes, what would that be?

46:36I'll go independent as soon as possible like that is one thing where I'm just like man I wish I would have went independent I wish I would have had more confidence in my own ability to figure things out and especially before getting married and before having kids like take like obscene amounts of risk career risk that is because you essentially have you can do crazy things like you can live in a one-bedroom apartment with two other people you could just like work and have a good time and I really wish I would have done that more aggressively and so you know I'm 40 this year and I feel like It took me years to figure out what my path would be through a bunch of, how many jobs have I had?

47:1010 different W-2 jobs. Just really trying to find, why does this feel so weird? Why am I not gelling with the people that I'm hanging out with all day? And just realizing that I'm different and that if you are different and you don't feel like your W-2 placement is really the right thing consistently, it took me 15 years to figure that out, then figure out a way to go independent before your life gets all complex. And I wish I would have done that earlier. It's this trite wisdom that people say, follow your passion or find your passion. We're really, there's nuance to it. It's basically find more and more of your passion.

47:41So you might know that you want to go into business and then for five years, you're doing something else. And then you're like, I want to go into finance and then you're in finance. And then you're like, I want to go into taxable. And then you're in taxable. You keep on distilling your passion closer and closer and getting to, it's almost like this asymptote where you're never going to truly find your exact passion, maybe till the end of your career. but the more closer that you could kind of fly to that to the top of the curve is is the more satisfied you'll be in your career i mean that's exactly it you know like you know you're going to iterate you know find the thing that maybe you're uniquely drawn to uh what did arnold say you want to you want to mine your obsessions and uh you know i think that that's actually pretty applicable especially to um you know certain certain types of personalities you know find the thing that you just cannot let go and then just realize that like if if you are doing it particularly better than the rest of the marketplace, maybe you're the only person who's doing it.

48:30Like in my case, I feel like I'm the only one writing about this stuff. Then there's an opportunity to leave that category. I was going to ask you about that because when I started this podcast, it was a big risk. I'm like, is this too niche, GPLP? You started an entire community and some would argue a career around alpha for taxable investors. It's one of the most niche topics I've seen covered. And yet you've grown so much. Now you have a conference. How did you know to take that chance? And were you worried that it might not end up that well? Yeah, yeah, totally. I mean, that that is the risk of like carving your own path is that the shape of your career, like it's totally weird and like a blob.

49:07It's not a straight line. The path is not hard for you. You're not trying to get promoted in somebody else's schema. Like instead, you're just like, I'm gonna post on LinkedIn today. And I'm gonna like figure out if there's audience for my nerdy interest in the mechanics of tax management. Oh, wow. It turns out there's a lot of interest in this. And there's also a lot of horizontal territory to cover. And like, is there audience for it? Well, oh, it turns out that there's an entire advisor community who sees this as the differentiator of their practices. And that finding the unique intersection of folks who are selling products into this space, and folks who are consuming these products and trying to get educated about that, that is the intersection that I live in.

49:44But I did not start that way. At first, I was just like, I'm going to write about the mechanics. I'm an engineer. This is nerdy. I can do some data visualizations or whatever. But no, I did not imagine that or seeing the world as clearly as I do now, not that it's totally clear, but I didn't imagine that up front. This was not designed. It was iterated into. We have the non-taxable, the institutional audience. We have the taxable audience. I fail to see any strategy that's more important for the taxable investor than tax alpha. Michelle Del Buena, who we were talking about before the podcast, he's a CIO of Andreessen Horwitz's family office, he said that they benchmark every one of their products against the tax aware aspect of it.

50:23So an active manager going back to how well an active manager and a non tax aware strategy, he or she needs to outperform the tax aware strategy by the tax alpha, which we talked about could be quite sizable. Well, Brent, I think what you're doing is amazing. Your sub stack, your conference, how should people follow you and learn more? well so i use the cringe platform linkedin uh with some regularity but i'm hanging out more on x now x is a lot of fun so um also tax alpha insider.com is my sub stack and um the conference is called basis and this iteration is called basis northwest but we'll probably be coming to a town near you pretty soon well brent uh thanks so much for jumping on and looking forward to doing this again soon well appreciate it david thank you for having me